Apr 9, 2013 - What happened in the stock/bond markets last week?

From James Investment Research, Inc

Stock Market Analysis 4/1 to 4/5

Conclusions: The market fell last week. We haven’t said that very much this year but it’s true. The Dow only fell 0.09% but the S&P 500 fell 1% and the Russell 2000 small cap index fell almost 3%. Strangely, five times as many stocks hit new highs as new lows while 1000 more stocks fell than rose. Transportation and basic material stocks led the decline while more defensive securities are becoming more attractive. It has been a long time since we’ve seen telecom and utility stocks lead the market.

Earnings guidance has not been strong recently. Morgan Stanley reports that recently negative earnings pre-announcements for the first quarter of 2013 have outnumbered positive pre-announcements by 3.5 to 1. The average since 2005 has been 2.3. The last time this ratio was this high was in the third quarter of 2007.

Doug Short points out that the Cyclically Adjusted P/E ratio is now higher than 87% of its history. Ominously, the remaining 13% of higher valuations includes the Tech Bubble and the 1929 Peak. We have already surpassed prior bull market valuation peaks reached in 1906, 1936, and 1968. Indeed, our research has shown that subpar stock returns can be expected when the CAPE ratio is greater than 20 as it is now. This is not to say that stocks must decline, rather that this is not the start of a new bull market and active management will be necessary to achieve good risk adjusted returns going forward.

Sentiment has been growing more bullish as even retail investors are jumping on the market rally. Many sold out after the market low in 2009 and now are having a hard time justifying 0% returns in money market accounts. Our Fed, the European Central Bank and the Japanese Central Bank are all pushing investors into higher risk assets through easy money policies. Unfortunately, even as this policy has helped stocks, it hasn’t righted the economic ship. Eventually stocks reflect the underlying economic value of businesses and we may have gotten ahead of real values.

Warren Buffet talks about the “Natural juice of capitalism” which pulls the economy forward. Reports this last week show a very diluted “natural juice.” Both the service and manufacturing areas have seen reversals and new orders, apart from aircraft, are anemic. The continued weakness in employment and the record levels of citizen dependency on government assistance further illustrate the ineffectiveness of government juicing.

Our leading indicators have finally edged out of the neutral camp into a slightly negative posture. However, they have been joined by the vast majority of our coincident indicators. After a 23% rally from last June, we think the market is peaking and starting to offer more risk than reward. We may have another bounce or two left, but we need to begin shifting our focus to preserving capital. As such, we will start to reduce equity levels in overinvested accounts.

Barry R. James, CFA, CIC

Bond Market Analysis 4/1 to 4/5

Conclusions: Last week, long term U.S. Treasury Bonds were up 4% while High Yield bonds were only up 0.1%. U.S. Treasury rates declined each day with the exception of Tuesday. We have been pointing out the benefits of Bonds in recent studies. Our founder, Dr. James, reiterated those comments on CNBC early last week and indeed, we saw the Bond market respond positively to the weakness in stocks.

Commodities were hit hard last week. Oil declined 2.74%, gasoline declined almost 8%, and corn declined almost 10%. The U.S. Dollar strengthened over 3.4% against the Japanese Yen and weakened slightly against the Euro and the Pound as the focus was on Japan.

The U.S. Employment report was a disappointment. The headline number of jobs created was 88,000 but this was below even the lowest economist estimate. The unemployment rate dropped to 7.6% but only because 660,000 Americans stopped looking for a job. The percentage of Americans participating in the workforce is now back to 1979 levels. Since January 2009, only workers 55 and older have seen a net increase in jobs, workers between the ages of 16 and 54 are still short almost 3 million jobs.

Unfortunately, ECRI reports that if you ignore seasonal adjustments, the Year-Over-Year (YOY) change in Total Nonfarm Payroll Employment and Total Household Survey employment are running at 19 and 18 month lows respectively. In their words, “Quite simply, U.S. job growth is worsening, not getting better.”

The Bank of Japan (BOJ) has been in the news recently for actions that George Soros called “dangerous” and could cause an “avalanche” in their currency. The BOJ announced that they are going to effectively double their monetary base by the end of 2014 in order to “stimulate” the economy. The problem is, they’ve been trying this approach for decades and it hasn’t worked.

Japan is trying to stimulate the economy by weakening their currency and increasing asset prices. The problem is their central government debt is 20 times their central government tax revenues. If interest rates increase by a couple of percent (as investors demand additional compensation for the likely depreciation in the Yen) their entire government budget will be needed to pay the interest on their debt.

Our bond indicators have been favorable for many weeks and they strengthened again this past week. We would continue to hold high quality bonds with moderate durations.

Matt Watson, CPA
Barry R. James, CFA, CIC